The end of the bull run

Will the slump in the Spanish residential market affect the commercial and investment sectors? Claer Barrett finds ou.t

Whatever your views on Spanish property, the unluckiest guy in the Madrid property market is the property lawyer working on the anticipated €4bn (£2.7bn) sale and leaseback of the Banco Santander portfolio.

The biggest transaction of its kind, the proceeds of the sale which involves the disposal of more than 1,000 properties occupied by the world’s fifth largest bank are intended to finance the September battle with the Royal Bank of Scotland to pluck ABN Amro from the jaws of Barclays.

This sets a challenging timetable: exchange by the end of July and completion by the end of August. Market folklore has it that the lawyer in charge is firmly in the doghouse after telling his wife to cancel their four-week holiday and instead endure the inferno of Madrid in August.

As the legal teams sweat it out, some would argue that the clock is also ticking for Spain’s overheating property market.

The cracks in the residential market have been well publicised (Property Week, 15.06.07). Massive oversupply, coupled with rising interest rates, has forced a correction in residential pricing, which the whole of Europe is nervously watching.

This summer, the market will find out if the storm clouds are also settling over the commercial market. There are some very coherent arguments why this will not happen, but the facts seldom get in the way of good old-fashioned market sentiment.

Falling share prices across the Spanish quoted property sector have disturbed an international market that is still trying to make sense of surprise purchases of trophy assets in the UK by Spanish investors prepared to pay high prices at rock-bottom yields.

In the meantime, the Spanish investment market is scorchio. RREEF’s head of global real estate and infrastructure research, Peter Hobbs, ranks Madrid as an ‘overheating market’, along with London, Dublin and Mumbai.

‘Compared to others, I’m quite negative on Spain,’ he says. ‘The market is at pains to point out the differences between the resi and commercial markets. They said the same in 2000 that rents would hold up. They didn’t. There is a lot of new supply, with concerns over the economy and concerns on pricing.’

Today’s investors are at pains to point out how different things were a decade ago. Spain’s ascension to the European Union brought an end to currency risk, widescale infrastructure improvements and fostered an economy in which construction specifically housebuilding has been a key driver.

‘Spain has produced 800,000 residential units a year over the last three years that’s the output of the UK, France and Germany combined,’ says José Berregón, managing director of ING in Spain and Portugal.

‘If a Spanish company has a market share of 10%, that’s equivalent to a 10% share of the three biggest markets in Europe. The tremendous cashflows have accelerated the Spanish acquisition of companies worldwide and investment in foreign real estate.’

Among Spain’s acquisitive conquistadors are Grupo Ferrovial, Sacyr Vallhermoso and banking giant Santander, which sponsored the British Grand Prix. Cash-rich Spanish property companies are diversifying into commercial real estate and aggressively pursuing large cross-border investment transactions, typified by Metrovacesa’s £1.09bn purchase of the HSBC tower at Canary Wharf in April, likely to be the first of many. Lower down the scale, Spanish housebuilders are diversifying into central Europe.

Borregón notes the trend for buying land for housing in central Europe, citing Poland, the Czech Republic, Romania and Hungary as four hotspots.

‘Spanish housebuilders are used to very high production rates that the home market is not allowing them to maintain,’ he notes.

The Spanish desire to obtain balance by investing in commercial property has made the investment market notoriously tight for foreign investors, resulting in yields of 3.5%.

‘The investment market has got down to hot levels,’ says Roger Cooke, head of Cushman & Wakefield’s Madrid office. ‘It’s the locals that have driven it down to that, not the internationals.

‘Why are they paying such prices? There are good rental growth prospects although there would have been a lot more a year ago plus the Spanish need to diversify out of residential into commercial, and out of development into investment.’

Some predict the time will come for Spain to diversify out of commercial real estate and sell off some of its tightly held assets to cross-border investors clamouring to gain entry.

‘We’re going to see sales of commercial product in certain cases, in large volumes from some Spanish property companies that need to cover the lack of traditional results being made from house sales,’ predicts Borja Sierra, head of Savills’ Madrid office.

Fears of overvalued property and land assets have led to falling share prices across quoted property and construction companies in Spain.

‘There is a saying in Spain: evil for all is evil for no one,’ says Sierra. ‘The banks are not yet putting pressure on to sell, and any sales will not be an opportunity for distressed or opportunity buyers. There is still enough liquidity and strong market sentiment to attract prime and core buyers.’

Prospects are mixed for the Spanish office market. Research from CB Richard Ellis shows that, despite low vacancy rates in Barcelona and Madrid, the office development pipeline as a percentage of total stock is the highest in Europe (see graph).

Take-up in both cities has been strong, which has resulted in eye-popping rental hikes of up to 25%, but it is now on the wane.

If you invested in Madrid two years ago, you’re laughing. If you didn’t, you’re too late now.

Will Rowson, ING

Jones Lang LaSalle data shows that prime rents in Madrid have increased by 58% since the beginning of this year, from €24/sq m/month to ¤38/sq m/month, although the rumour among agents is that a rent of €42/sq m/month has been achieved in one Real Madrid office tower.

‘If you invested in Madrid two years ago, you’re laughing. If you didn’t, you’re too late now,’ sums up Will Rowson, head of European acquisitions at ING. ‘International investors have moved on to Paris and, to a certain extent, Frankfurt.’

Funnily enough, the most active occupational sector is banking. Madrid’s Torre Repsol, which is 100% vacant, is tipped to be under offer to Caja Madrid, one of Spain’s largest savings bank, for its own occupation. Depending on whom you believe, it is paying anything from €500m to €750m (£338.4m to £507.6m) for the Foster-designed 250 metre tall tower.

A month ago, BBVA, Spain’s second largest bank, engineered a €700m (£473.6m) purchase with Spanish property company GMP of its Foresta business park on the outskirts of Madrid for its own occupation.

Capable of taking its 100,000 sq m (1.1m sq ft) requirement, the developer negotiated out of a prelet of 25,000 sq m (269,100 sq ft) it had signed with PricewaterhouseCoopers.

Under the deal, which reflected a 4.25% yield, BBVA swapped development assets in central Madrid it owns or occupies.

The other international companies now in the frame for a slice of the €4bn (£2.7bn) Santander portfolio shows the strength of interest in the Spanish market.

Other internationals active in Spain are Carlyle Group, which recently purchased Barcelona’s Telefónica tower for €221m (£149m), Doughty Hanson, Babcock & Brown, Hines, Quinlan Private, British Land and Grosvenor. The last two have made big inroads into development.

Funds such as ING, Henderson and Invesco are also active. Australian and Middle Eastern money in particular is being funnelled in to the Spanish market.

The sheer size of the Santander sale has led the market to regard it as a financial play, rather than a real estate transaction. The real cross-border investment activity is today is in the retail sector.

Jones Lang Lasalle data shows that last year, 12% of the total value of the Spanish retail property investment market changed hands, and more than three-quarters of this was shopping centres. Totalling €2.9bn (£1.96bn), this represents a 46% increase in investment volumes in Spain. International investors accounted for 87% of all retail purchases.

The success of these international investors in the retail sector could be shortlived: if the residential storm clouds spread, retail oversupply is a real prospect.

‘Spain has the biggest retail development pipeline in Europe,’ says Steven Weaving, director of retail investment at Jones Lang LaSalle.

Weaving says that 1m sq m (10.8m sq ft) of retail has been delivered across Spain every year for the last three years. A further 10.8m sq ft a year will be delivered for the next three years.

‘Within that pipeline, there is an element of providing space in “next tier” towns,’ he says. ‘Developers are building schemes in smaller towns of up to 60,000 people, as the retailers can see the potential for smaller stores within an affluent catchment area.’

However, most large development projects are in big cities and towns.

Rising retail rents have encouraged international investors, who are salivating at the prospect of more rental growth.

‘Rents in the UK for similar-sized shopping centres are double or treble those in Spain,’ says Weaving. ‘The profit margins that retailers take in Spain are much higher than the UK. It has always been argued there are opportunities across Europe to increase retail rents.’

But in the face of rising supply, and the Spanish market’s reliance on turnover-based rents, this may prove tough to sustain.

‘The only sector where you could make comparisons with residential is retail,’ says Sierra. ‘A number of projects look badly planned, and there are areas of the country where the retail offer is looking congested.

‘Retail developments have been based on residential expansion plans. There are a lot of new houses, but half are empty. You are not going to see the flow of consumers expected.’

One sector heralded by all as overlooked in terms of yields and development potential is the industrial and logistics market. But with the lower values associated with this sector, it is not going to be everyone’s saviour.

Spanish real estate fever is at its height. Investors taking their chances will be nervously sweating it out.